High risks in high deficts
Indian Express, 27 July 2006
Consumer prices in June 2006 were 6.5 percent higher than in June
2005. Last year in June price rise over the previous year was less
than 4 percent. The government has tried to combat the sharp increase
in inflation by a combination of supply side measures and higher
interest rates. Undoubtedly, the impact of these steps is more direct
and visible, while that of fiscal policy is not. But when the
government is trying to restrict private expenditure by raising
interest rates, is there not a case for it to restrict public
expenditure too?
Ironically, what we find is that even in these taxing times when there
is acute pressure on prices to rise, arguments are being made to
abandon even the legitimate restraint that Parliament places on
government through the Fiscal Responsibility and Budgetary Managment
(FRBM) Act.
Considering that inflation is only one of the dangers of large fiscal
deficits, where external indebtedness, inflation, large interest
payments, reduced private investment and debt default are some of the
others, this is a very unwise argument.
One option is that the government finances additional expenditures by
simply printing money. India has tried it in the past, suffered high
inflation and then wisely put an end to this option. The central
government no longer has the power to print money to spend. What it
can do, instead, is to borrow money from the public and from
commercial banks.
But if the government's deficit exceeds the amount the domestic
private sector lends to it, the country as a whole now spends more
than it produces. It imports more than it exports. The additional
spending has to be financed by capital inflows like FDI, FII or
foreign debt. For any given domestic savings rate in an economy, if
the government borrows from the public, then either domestic investors
get to borrow less and investment goes down, or the sum of borrowing
by the government plus private investors must be met by capital
inflows from abroad, or foreign savings. Foreign capital inflows like
FDI and FII happen when the economy is doing well. Foreign equity
inflows are deterred when India runs large deficits. So large deficits
tend to go along with large offshore borrowing.
The Indian government ran large deficits in the 1980s and ended up
hugely indebted to foreign lenders by 1991. Now again, if we raise
deficits and if foreign investment is inadequate to meet our deficits,
foreign debt could build up.
Morevoer, the goverment often gets preferential treatment as a
borrower both from public sector banks and from those with a lower
risk appetite. Private borrowers have to compete for a smaller share
of savings as the government pre-empts savings. It thus "crowds out"
the private sector by pushing up interest rates and reducing private
investment.
Further, high fiscal deficits mean high public interest
liabilities. The more the government borrows today, the greater are
its committed interest liabilities in the future. This reduces the
flexibility it has with spending. Last year interest payments took
away two-thirds of taxes collected. If the state of public services is
poor today, then the blame partly lies on the fiscal profligacy of the
previous governments. If the state of infrastructure is poor, if roads
are badly maintained, if the government has not had the money to
invest in new airports, ports or power plants, the problem is not
unrelated to the size of past deficits. If we run higher deficits
today we are tying down the hands of future governments who will end
up using all their tax collections to pay for our expenditure today.
As the government continues to run deficits and borrows more and more,
there comes a time when the government is borrowing only to repay its
debt. It starts running a "Ponzi scheme" named after the innovative Mr
Ponzi who ran a nice little racket, borrowing from B to pay A and from
C to pay B and so on. As the size of the debt increases this could
lead to a situation in which the government thinks it is better to
default on its debt. In India we have not yet worried about the
possibility of default, but the current level of the public debt is
very high by world standards. As it rises further, there would be
fears about the government defaulting on its debt obligations. Not
only will millions of households lose their savings in post-offices,
National Saving Scheme, PPF, GPF and RBI bonds, the banking system
which holds about 85 percent of government debt will lose
heavily. This would hurt millions of households across the country.
It is very easy today for the government to spend crores of rupees on
welfare schemes financed by deficits. The voter is unable to
comprehend that he is paying for them through higher prices. Yet,
while doling out borrowed money to win votes might seem to be an
attractive option, it should be remembered that the inflation
tolerance of the Indian consumer is low, and the end of the day high
deficits may prove to be very costly.
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